By Ben Sills Oct. 23 (Bloomberg) -- European Central Bank President Jean- Claude Trichet may need to show he's still inflation fighter-in- chief after price expectations soared in the wake of the bank's Oct. 8 interest-rate reduction. Economists at Deutsche Bank AG say the ECB will slash the benchmark rate to a record low of 1.5 percent by the middle of next year from the current 3.75 percent as the euro-region economy heads into a recession. Other economists say that underestimates Trichet's commitment to combating inflation. ``We're a bit more cautious,'' said Kenneth Broux, an economist at Lloyds TSB Plc in London, who sees the key rate dropping to 3 percent. The financial crisis ``hasn't solved the inflation problem.'' The bank ignored inflation at almost twice its 2 percent limit when it joined the global round of rate cuts. The five- year/five-year forward breakeven rate, the bank's preferred gauge of the medium-term inflation outlook, has jumped 14 basis points since the cut, to 2.5 percent. It wiped out almost half the decline that followed the ECB's initial October decision to keep the main rate at a seven-year high of 4.25 percent. Trichet described the first rate reduction in five years as a ``signal of confidence'' to markets. The move, which followed the worst stock-market drops since the 1987 crash, marked a shift in the bank's focus toward economic growth and away from its usual preoccupation with prices, said Dario Perkins, senior economist at ABN Amro Holding NV in London. `Different Objective' ``It's quite clear that they have changed,'' said Perkins. ``All the talk was about confidence and that's a different objective from what they had at the beginning of October.'' The ECB raised rates as recently as July. Investors expect the ECB to lower rates by at least a quarter point on Nov. 6 and a further half point to 3 percent by February as the credit crunch hits Europe, Eonia forward contracts show. Deutsche Bank's chief European economist Thomas Mayer expects a 1.4 percent contraction in the economy next year. The financial crisis is fueling a debate that's smoldered since the ECB was set up in 1998 on how the central bank should interpret its mandate. While the Maastricht Treaty of 1992 sets out price stability as the ECB's ``primary objective,'' the bank also has scope to support the European Union's ``general economic policies'' once inflation is under control. Change of Brief? ``The crisis is taking central banks away from their traditional mandate,'' said David Bowers, a consultant with Merrill Lynch & Co. in London. ``The fact that the ECB has been forced to move comes pretty close to a change in their brief.'' Sweden's central bank today cut its lending rate for the second time in two weeks, by a half-point to 3.75 percent. French President Nicolas Sarkozy and predecessor Jacques Chirac have led the push for the ECB to do more for growth. Even former Spanish central bank governor Luis Angel Rojo has broken with central banking convention and criticized his former colleagues, saying in an Oct. 20 interview that price stability ``shouldn't be their only objective.'' ``In certain situations, including the present one, they haven't given enough attention to other problems such as the decline in economic activity,'' Rojo said. In an interview yesterday, Spanish Economy Minister Pedro Solbes said that with the ECB's inflation ceiling ``more achievable,'' the bank would give ``more weight'' to the pace of growth when setting monetary policy. Finland's Finance Minister Jyrki Katainen told Bloomberg News that the European economy may take up to three years to escape recession. Market Slump The ECB's rate cut came as Europe's benchmark index, the Dow Jones Stoxx 600, suffered its worst week on record, dropping 22 percent. The euro has plunged 13 percent against the dollar in a month, to a two-year low yesterday, as concerns mount that the euro-region economy is slumping. Trichet may be more comfortable with faster inflation until the current crisis abates even if he doesn't admit it, said Julian Callow, chief European economist at Barclays Capital in London. The danger is that an extended economic slump would push down prices and wages just as banks restrain the flow of credit, increasing the risk of a deflationary spiral. ``It's prudent to allow for those risks in setting the rate and therefore this implicitly means you should accept a higher inflation rate than otherwise,'' said Callow. ``The ECB is tilting this way for sure.'' Trichet denies the bank has taken its eye off inflation. He argued after the rate cut that the financial crisis eased the inflation outlook, giving the ECB room to act. Risks Materialize ``There has been a materialization of the downside risks to growth and we have to take that into consideration in all respects, and particularly as regards the influence that it has on the upside risks for price stability,'' Trichet said in New York on Oct. 14. In an interview on French radio on Oct. 19, he described the 15-nation euro area as being in a ``very, very important growth slowdown.'' ``Whether that means inflation is suddenly going to fall enough is highly doubtful,'' said Broux. ``Unemployment is the lowest in a generation.'' While oil prices have halved in the past three months and inflation slowed to 3.6 percent in September, workers are demanding compensation for higher costs. Germany's IG Metall labor union is seeking an 8 percent pay increase, the largest in 16 years, and workers at Ireland's Electricity Supply Board last month demanded 11.3 percent. `Sticky' Inflation Elga Bartsch, chief European economist at Morgan Stanley in London, said ``sticky'' inflation means the ECB will cut rates less than the 275 basis points of easing in its last cycle. She expects a reduction in the key rate to 3 percent by mid- 2009 because the central bank never completed its tightening campaign and because costlier fuel and finance have reduced the region's non-inflationary growth potential. Cutting borrowing costs too much also risks repeating the mistake made by the ECB and the Federal Reserve earlier this decade, when rate reductions helped fuel asset-price inflation, said Gilles Moec, an economist at Bank of America in London. ``The challenge of 2009 is to cut rates sufficiently to avoid a catastrophe, but without feeding the next bubble,'' he said. ``Political pressure will be extreme, so they will have to fight.'' To contact the reporter on this story: Ben Sills in Madrid at bsills@bloomberg.net

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